Gold Prices Continue to Climb

So far in 2009, the S&P 500 is up 21%, while gold is up nearly 25%. Gold and stocks have been moving in tandem for much of the year, an unusual situation, to say the least.

The rising stock market has been one of the few bright spots of the economy. While it’s difficult to say what causes short-term movements in stock prices, the year’s increases in the stock market is probably not connected to the performance of the economy, actual or perceived.

I say this because the rally has not been driven by outside events. At the low of the market, in March 9, 2009, the sentiment was bleak. Analysts who had previously been known as solid bulls began to say, “the sky is falling!” News since then has been solidly bad, with continuing job losses, rising unemployment, trade deficits, budget deficits, and a rising disillusionment with the Obama Administration. Now sentiment has reversed; everywhere the talk is of green shoots and growth; all experts agree: the recession is over. They point to the performance of the stock market and the recent rise in GDP (mostly driven by debt-funded government consumption).

It seems more likely that the rally is a correction of the long slide in stock prices that took the Dow down 7500 points over a period of about 17 months. The nature of markets is action and reaction, movement followed by countervailing movement. The stock rally of 2009 is simply a long counter-movement, where the market recoups a portion of its losses. The general rule to look for is a counter-movement of 50%, though it may be as large as 75%. The former has basically been achieved. That means extreme caution is warranted about future market moves. Indeed, it seems to me that the sentiment has become so uniformly bullish that the only possibility is a sharp downward movement, even an eventual violation of the lows of March 2009. This possibility is not driven by sentiment alone, but by the fundamentals of a weak economy coupled with the multiple threats to the dollar’s reserve currency status.

Right now it seems unthinkable to nearly all observers that the dollar could be displaced. That alone should give us pause. The last two years have been a time when most observers have been disastrously wrong. Most did not foresee the crash of October 2008. Most did not foresee the rapid downturn of February 2009, nor the rally that began in March. Early in 2009, when oil prices dove to below $40, most analysts predicted they would stay there; instead, they doubled within the year, in the face of worsening economic deterioration.

Yet India’s purchase of 200 tonnes of gold from the IMF at near-record prices shows that nations are increasingly distrustful of the dollar. Individual investors should take note.

The Rally Continues!

Well, I went on vacation and that market made a fool out of me while my back was turned!

Far from the rally running out of steam, as I predicted (here and here) the rally merely paused, then continued steeply upward, revitalizing the talk of recovery and green shoots.

Gold has gone back to tracking the market, and has also done well, as has oil. This makes me wonder if the surging stock market isn't really an early sign of inflation. This is what can happen in financial markets - they act as a canary in a coal mine, sending off inflationary signals well before consumer prices are affected. But these signals are hard to read. We generally think a rising market is good, and it carries us along in a bullish daze. Even my phrase "done well" to indicate "rising price" is a sign of the positive spin we put on it.

But I wonder what the market is up to. All that money the Fed created has to go somewhere. A lot of money is still on the sidelines, waiting to get back in. Barron's asked recently, should you get in or get out? Could this be the time that the Dow chooses to get back above 10k, even claim 11k?

I do not believe that the worst is over. The economic restructuring that is inevitable has barely begun. But a rising market has a way of making us all feel better. The sooner we face the need to restore the balance between productive and unproductive labor, the better. We need to shake out the debt, and we need a sound currency under the dollar, which is sadly and hideously overvalued.

Microsoft Issues Bonds, Contemplates Drinking Own Urine

Microsoft has completed a new bond issue, its first ever, for $3.75 billion. The company says they have no real plans for the money, though the move has sparked speculation about possible acquisitions. They say they're just taking advantage of favorable market conditions.

Apparently some analysts think that the most likely use of the money would be a stock buyback, where the company buys its own stock, attempting to push prices up. Microsoft stock has been hit by the falling market, along with everything else. The stock was at $30 early in 2008, and it fell below $15 by March 2009.

The stock buyback is a corporate strategy that is emblematic of the first decade of the 21st century. Stock buybacks exploded during that time, as they did during the end of the 1990s. Of course, most buybacks are done with borrowed money. The tactic is considered an acceptable way of paying out profits to shareholders.

A company buying its own stock with borrowed money is doing something as sensible as drinking your own urine. At best, it keeps you alive in the desert. But it sure won't make you thrive. Borrowing money imposes an economic logic: you must pay back more than you borrowed. So if you're borrowing to invest, you'd better make sure that what you invest in has a higher return than the interest rate, plus some for inflation, and a normal rate of profit. How does a share buyback accomplish any growth whatsoever? If all goes well, and the stock price remains high, (far from certain in this volatile market) how exactly does that insure the future growth of Microsoft?

The real motivation for the skyrocketing use of buybacks is so that management can give themselves fat bonuses covertly, in the name of shareholder value. Now that the credit teat has been taken away, my guess is that we'll see far fewer share buybacks by corporations. It was a strategy of the bubble years, one that is doomed to extinction.

Oil and Stocks

After skyrocketing to a high of $147, then crashing to $30, crude oil has rebounded to nearly $60 a barrel. (Some good analysis of the oil market can be found at wtrg.com)

Will this cause the economic "green shoots" to wither?

Nah. Unfortunately, there are no green shoots. And the oil rebound is a technical matter, caused by the rising stock market. This market rally is causing "mini-rallies" in other assets; this is because at the end of the great market boom of 1980 to 2007, every asset in the world had become severely overvalued, from stocks, to real estate, to commodities, to art; you name it, it was overvalued. An ocean of fiat money was pushing up prices in everything that could possibly be an investment good. The bear market in stocks has also been a bear market in all of these alternate investment assets, including the king of bear market commodities: gold. (Let me hasten to say that the fall in gold prices is a temporary phenomenon, a secular bear market within a bull market that began in 2002.)

Oil presents us with a paradox. Are prices rising because demand is stronger than we thought? That would be a good thing. Or will the rising demand quash consumer spending? I'd say neither. Look for oil prices to continue upward as the stock market rally continues, but I expect oil to correct down sharply as the rally ends. Of course, the long term trend of oil is up, both because of inflation and because of the geological reality of peak oil.

Stocks Continue to Rise

The Dow had a good day today, rising 101 points to break the 8500 mark.

If you bought 370 shares of DDM at $26.93 when I recommended it, you'd now have $10,807, an 8.3% return after trading fees (assuming $9.99 per trade).

It feels like the conventional wisdom is that the market has bottomed, and a new bull market has begun. A substantial minority opinion holds that the Dow is in a bear market (or "sucker's") rally. But the big money seems bullish, judging by a recent Barron's survey finding that 59% of money managers are either "bullish" or "very bullish". Since big money drives the market, it is wise to heed what the big money managers are thinking and feeling. As the rally continues, their doubts will fade, and bullish sentiment will increasingly dominate.

The strategy I'm proposing is a risky one, requiring some vigilance to carry out. I believe that the primary trend of the market is bearish, so this strategy looks to the secondary trend, which is even less predictable than the primary trend. Use caution, only invest as much as you're willing to lose.

At some point, when the market rally is nearing its end, we'll want to switch to DXD, which moves inversely to the Dow.

New Forecast for the Dow, New Feature for the Blog

In a previous post, I gave a prediction for the Dow to rise to 8300. Given what has now happened, I'd like to revise that. The Dow has just broken through its most recent high mark (of Apr 17th), and I now see the rally taking the Dow back above 10,000.

Which brings me to the new feature of the blog. I give my calls, and we'll see how a hypothetical $10,000 invested as I say will do over time, assuming a trading fee of $9.99.

Since I see the market rally continuing, I'm taking a position in DDM, which is a leveraged ETF (exchange-traded fund) that returns twice the daily performance of the Dow. I'm going to start the clock now, even though I bought DDM a few days ago. I'm going to say you can pick up DDM at its current price of $26.93, you can get 370 shares. (More if you're on margin, but let's keep it straight.)

I don't believe the bear market is over. I think the Dow will still fall to the 1000 range or below. (In a previous post, I called for 400). The reality is that the stock market has been on an outrageous tear for 27 years. That kind of growth is not corrected by an 18-month bear market, even one of this severity.

Once this rally has tapped out, I'll call for taking the opposite side, with an ETF called DXD, which moves double the inverse of the Dow.

How Long Will the Stock Market Rally Last?

Here's where I go out on a limb. My feeling is that the rally will take the Dow to 8300 or so, before the market returns to its downward course. How long will that take?

On the one hand, the rally that began after the March 9th low has only been around 5 weeks, but already it has wrought a powerful change in sentiment. There is big money on the sidelines hoping to recoup some losses. Some have no doubt been tempted to get back in.

On the other hand, it feels as though the rally has already begun to cool. Yes, the last few days have shown gains, but it feels like the winds are changing. Perhaps we'll see the market move sideways for a while, as it did today, ending flat (+5.90 or 0.07%).

The recession is just beginning. How will the market respond to further bad news? Has the market discounted all the bad news? Has the market already looked ahead?

I don't think so. The conventional wisdom is that the recession will last the year. My own view is that we are in for a 5 to 10 year recession.

An interesting possibility is how the market may respond to the inflation that is coming soon, once the deflationary pressures have abated. Will stocks leap ahead, encouraging investors that the bear market is over, a rally that is stimulated by inflation, not real underlying growth? That is a distinct possibility.

Did Mark-to-market Accounting Destroy the Economy?

Mark-to-market accounting basically means that assets will be valued according to what the market price of the asset at the time. This is a commonsense practice. What is your house worth, what is your car worth, what is your time worth? The answer is the same for all: it is worth what the market will bear.

Frank Holmes argues that this simple and commonsense practice (recently suspended by the Financial Accounting Standards Board, here is the original guideline) says yes, in a recent article on the Kitco website. Unlike most analysts on this issue, he provides some data. Holmes argues that the FASB accounting rule (implemented at the beginning of 2008) caused a vicious cycle: the rule caused banks to write down losses that were at that point unrealized, which then caused them to be under-capitalized, causing them to then restrict lending.

Here's his chart (in $bil):

What makes Holmes' argument spurious is that the very time when the graph begins its sharp descent corresponds with the end of the peak performance of the stock market (the Dow hit its record in Oct 2007, with a long downward slide since). (To be fair, Holmes notes this when he says credit market became 'impaired', meaning they were on the way down, but because of rigidity in some derivatives markets, supply and demand did not clear.)

It simply does not matter whether banks 'realize' their losses or not. As long as the market value of the asset is below what they paid for it, there is a loss. If a person buys a 1000 shares of a stock at $10 a share and that stock falls to $7, that person has lost $3,000. If he sells, the loss is realized. If he decides to keep the stock, he has a paper loss, or an unrealized loss. Perhaps he decides he doesn't want to take the loss, and hopes the market improves taking the stock back to $10, or even above. Fine, but that doesn't change the fact that the asset is worth $7,000 today. No amount of wishful thinking will change that, and this is why the suspension of mark-to-market accounting will do nothing to solve the financial crisis.

In fact, the FASB rule did not cause banks to restrict lending. It simply revealed how short banks are. That information was readily available well before FAS 157 (the mark-to-market rule) took effect. Federal reserve data shows that bank reserves had fallen to well below 1% of deposits. That only works during the boom years; when markets began to flag, and then seriously head downward, banks pulled back their lending because they saw banks failing, being taken over by the FDIC, and those that were still left standing panicked, beginning a mad rush for deposits that took bank reserves to about 12% (as of 4/8/09, reserves $861 bil, deposits of $7,361 bil). Eric deCarbonnel has a nice article on bank reserves steadily moving to basically zero.

It was the over-use of leverage that created the conditions for the financial collapse, and the main culprit is the fractional reserve banking system. Don't blame honest accounting for the collapse.

FASB Suspends Mark-to-market Accounting Rules

And the market loves it! The Dow is up 270 points as I write this. (Here's a link to a WSJ article on this development.)

Well, we should have known that with the steady drumbeat of analysis (examples here, here, and here) blaming the financial crisis on mark-to-market accounting that this would eventually happen.

Unbelievable. It is absolutely absurd to blame the financial crisis on mark-to-market accounting. What causes banks to suddenly realize that they have solvency problems is that they are insolvent every single day of every year; it's only that a dip in asset prices causes them to worry about it for the first time. Modern banks run on the fractional reserve system. During a credit boom, market competition pushes banks to decrease their reserve ratios, for this is key to higher profits. The Fed tends to look the other way as banks move assets around to avoid mandatory reserve requirements (either 10% or 3% depending on the size of the bank.) According to Fed data, aggregate bank reserves fell to 0.74% of bank deposits, showing that banks are adept at getting around mandated reserve ratios. (Reserves have exploded since the fall of 2008, showing the fear that has struck the banks.)

Allowing corporations more flexibility to value their assets (i.e. facilitating wishful thinking or outright deception) will not make this crisis go away, it will prolong it. The crisis will be over when markets clear. That requires accurate information, not opacity.

A Prediction for the Dow

In the spring of 2006, my father and I predicted a financial crisis would hit the US. (We assumed that this crisis would be driven by dollar depreciation, which has not yet occurred). We continue to feel strongly that the dimensions of the coming crisis are still not grasped by most Americans. In January 2008, I predicted the Dow would fall to 7000. Given what has now occurred, our concerns were mild. Yes, an estimated $60 tril of paper wealth has been destroyed globally, but there is much more to come.
Over the next five or ten years, the US will sink into a deep recession. Unemployment will rise dramatically as the restructuring of the American economy proceeds. We see the Dow falling to 400. Yes, four hundred.
Given the endless parade of bad news and bearish forecasts for the economy, it may seem that the worst has already happened, and there is nowhere to go but up. Indeed, some analysts (for example here and here) have called a market bottom. The US consumer is not spending, unemployment is rising, the highest officeholders in the land call it the worst situation since the Great Depression... you might say, how many other shoes are there waiting to drop (or be thrown)?
What has not yet occurred is a serious threat to the dollar's status as the world's reserve currency. That threat will come, for the world cannot continue to finance American profligacy. When the eventual flight from the dollar occurs, it will cause much worse damage even than the unbelievable carnage in asset prices (click here for a chart of the Dow over the last year) we've already seen.

Stewart vs. Cramer: Short Selling Backlash

[Written for the Borsen-Kurier]
Judging from the cable news cycle, the most important story of the last week in the US was a face-off between Jon Stewart, comedian and host of The Daily Show (you can watch the show here), Comedy Central’s fake news network, and Jim Cramer, a former hedge fund trader and host of CNBC’s Mad Money. How did it happen that arguably the most serious journalist in the US, virtually the only interviewer who is willing to ask truly tough questions, is a comic specializing in, as he puts it, “fart jokes”?
Stewart played a clip from the end of 2006, which showed Cramer being interviewed and revealing some of his secrets of short selling: “You want to spread rumors about the company,” he said, “it’s against the rules, but the SEC won’t find out.” After the clip, Stewart says: “I want the Jim Cramer on CNBC to protect me from that Jim Cramer.” Cramer squirmed and capitulated, trying to make it seem that he’s doing everything he can to prevent the kind of abuses he’s just been shown to be adept at, and promising to do a better job as a financial reporter. “That would be great,” said Stewart, pressing on, “but this is about more than you.” It’s about the network, the show, the whole focus on short-term gain at the expense of the little guy, about gaming the system, about the average investor “capitalizing your adventure”.
He’s right, of course, in that financial markets can function like a poker game. As Warren Buffett put it, if you’ve been playing poker for half an hour and you don’t know who the sucker is, it’s you. Shows like Mad Money are designed to draw in more suckers, who then make amateurish blunders, which the pros exploit.
What should be done?
It doesn’t seem to make much sense to try to ban rumor-mongering. But should we ban or try to restrict short-selling? Has short-selling caused the financial meltdown? Short-selling is the practice of borrowing shares, selling them, then waiting for a lower price, which allows the investor to buy back the shares, and return them to the lender, pocketing the difference. The practice of short-selling is having its 400th anniversary this year, and it remains controversial, because it puts the investor in the position of hoping for a decline, and for the last 400 years, short sellers have been blamed for causing markets to fall.
But such a position is untenable. Though it is true that every short sale begins with selling, and each act of selling exerts downward pressure on a stock, the number of short sellers in a market tends to be small, and short sellers tend to be professional (or at least experienced) traders.
Because markets tend to price in available information, rumors cannot bring prices down for long. If a stock is undervalued by the market, its price will eventually rise, just as overvalued stocks will fall. Short sellers do a valuable service by putting pressure on overvalued stocks. Either the shorts are correct, and the stock falls back to a lower value, or the shorts are wrong, in which case they lose money. There is no more effective discipline for traders than losing money. Blaming short-sellers for falling stock prices is like blaming a vulture for the death of a zebra. A vulture is incapable of killing a zebra, but the vulture obviously benefits from the zebra’s death; the rest of the ecosystem benefits from the vulture stripping the carcass.
Short selling did not cause the US stock market to fall. The stock market fell because it had reached a monumentally overvalued condition. To restrict short selling not only locks the barn after the horse is gone, it discourages traders from taking positions which correct overvalued prices.

What Caused the Stock Market Crash of 2008-2009?

[Written for the Borsen-Kurier]
What caused the US stock market to spectacularly crash in 2008 is intimately connected to what caused the market to boom from 1980 to 2007. In broad terms, the long market boom, which took the Dow from 875 to over 14,000 at its peak in the fall of 2007, was the result of two interconnected forces: money creation and redistribution.
Economically, the great puzzle to solve is not why the market crashed, but why it performed so far above the rate of economic growth for so long. Why should the stock market, which is composed of nothing more than a broad section of corporations, on average perform any better than the overall rate of economic growth, upon which it surely rests?
Consider the following graph of the stock market and M3, the Federal Reserve’s broadest measure of money creation (M3 was discontinued in 2006, but the series is kept up by several different private economists). Notice that the performance of the stock market (as measured by the Dow) is far above the rate of productivity growth or the rate of real economic growth.

The fractional reserve nature of most modern banking systems means that money creation takes place in a decentralized manner; during this period, much of that money found its way into financial markets, in the form of leveraged buyouts, stock buybacks, and the effects of increasing leverage on the part of investment banks and the explosive growth of the highly-leveraged hedge fund industry. Much of this borrowing went to purchase equities, bidding up prices dramatically.
At the same time, the shifting balance of power between labor and capital made it possible for corporations to hold down wage growth, resulting in an unprecedented 20 year period of falling real wages in the US. This caused corporate profits to increase, along with share prices, as stockholders re-evaluated the new distribution of income between labor and capital.
The problem, of course, is that neither of these forces are sustainable. The share of income going to labor can fall, allowing the share that goes to profits to rise, but labor’s share cannot fall far without producing resistance. In the US, that resistance was weak, in part because of a new innovation: leverage for consumers. Unfortunately, the new kinds of consumer credit that were invented and eagerly used by US consumers were rarely used for any kind of investment, so debts mounted without an increase in income to pay them back.
As for money creation, it must eventually lead to inflation. No one can truly create wealth out of thin air, so when money is created far in excess of economic growth it must cause rising prices somewhere. If it causes rising consumer prices, we notice it and demand a solution, but if it causes rising stock prices, we celebrate it. But the money is not real, and the prices cannot last. At this point, it seems likely that the Dow will fall to 5500, which would give the Dow a traditional bear market dividend yield of 6%. Given the extent of money creation thus far, a strong possibility is that the Dow shows strong growth, perhaps rising above 10,000, or even above its record heights. While this may reassure investors, such an outcome would simply be the first manifestation of inflation that will not be confined to financial markets this time around.